There are numerous signs an "el nino" is headed for the buyout industry.
When private equity funds were popularized as an asset class in the 1980s, bloated, mismanaged public companies acquired in massive debt plays generated large profits and were then spun, repositioned or refinanced by buyout titans.
Conditions for equity growth were matched to the design of large buyout funds. The economy was characterized by upheaval and uncertainty; liquidity was at a historic low; asset values were driven down as the banking system and real estate markets collapsed amid recessionary pressures; and corporate America continued to manage business strategies inefficiently.
All this has now changed significantly. Optimism is rampant; sources of debt and equity are abundant; seller sophistication has greatly increased; growth in productivity is setting records; and asset values are towering.
This is good news for stockholders in public companies, but bad news for the big buyout shops -- almost everything in the large-cap market is terribly expensive today.
It is hard to imagine the stock market increasing by another 400% in the forseeable future, or economic conditions providing the market lift to which buyout specialists have grown accustomed.
Buyout executives are increasingly whispering about the scarcity of attractive deals, and the potential for large returns is receding. Returns in the heyday of buyouts sometimes reached 40%. Recent data indicate venture capital funds had increased return on investment to a 27.4% average vs. only 17.2% for the buyout community. Suddenly, experts in the buyout field are fretting over the prospects of their mid-30% returns sinking to 10% to 15% for new funds -- and some suggest even worse.
Private equity still draws record amounts of money. It's estimated that $50 billion has been raised this year alone and that private equity coffers are brimming with $225 billion in unused capital, much of it in the hands of the large-cap, general purpose buyout funds.
How does the future look for private equity investors? Limited partners will have to look for greater creativity, innovation and specialization in their funds.
The new era of private equity will be one of decidedly diminished results for the large-cap, general-purpose buyout operations, with exceptions, such as health and technology.
Return-on-investment targets will be driven downward significantly as new technologies savagely redefine competitive landscapes and product cycles. Purchase multiples already have risen to 10 to 12 times cash flow for larger deals, compared with the six to eight times range in the "good old days."
This effectively has lowered actual rates of return as large-cap buyout firms "pay up" with equity and junior debt to close the capitalization gap.
Expect more co-investment as more highly capitalized buyout shops scramble for fewer deals. Buyout specialists will yield to the necessity of syndications or accept minority positions in public companies.
The large funds will look increasingly for offshore opportunities, creating the same self-inflicted wounds that supply-and-demand dynamics have wrought in the United States. The phenomenon already has begun to unfold in Europe, triggering a migration of investors to Latin America and Asia.
With increasing frequency, large-cap buyout investors are rationalizing purchase candidates as platform opportunities for growth so the return-on-income math is made to work. This introduces uncharacteristic elements of risk and uncertainty.
To consumers of private equity, we recommend smaller firms with a sharper focus, specializing in the lower middle marketplace where prices are more attractive and competition is less intense.
As Bob Dylan sang, "the times they are a-changin'."